Foreign institutional investors (FIIs) have always had a soft corner for India. In the past decade, since they were allowed to invest in India, except for one year, they have been net buyers of Indian shares and bonds, pumping in more than $17 billion till date. The love just got stronger. Even as retail investors are gingerly returning back to the stock market, FIIs are on course to make 2003 their biggest year, having invested $2.37 billion (around Rs 10,900 crore) in the Indian market since January.

The investment deluge from overseas has propelled share prices by an average of 20 per cent in the past three months, creating wealth and spreading cheer among investors. The total market capitalisation-which is the total value of all the shares on the stock markets-rose from Rs 5,46,000 crore on April 1 to Rs 7,13,000 crore on July 24. That's wealth creation of Rs 1,67,000 crore. An increasing fraction of this capital gains is accruing to small investors.

A more heartening fact is that a large chunk of the FII money-some say even up to 50 per cent-has come from foreign investors who had never invested in India before. They are buying furiously into shares across sectors and picking up bonds to the extent that they are close to touching the $1.5 billion limit on FII investment in debt instruments.

The number of FIIs operating in Indian markets has risen from 480 six months ago to over 500 now. There is also a sharp increase in the number of sub-accounts-some foreign funds prefer to invest through a sub-account of an already registered FII to save procedural hassles-especially from large pension funds. The number of sub-accounts is over 1,500, three times the number of FIIs registered in India.

Why are FIIs swarming to India? Investors offer many reasons: The Indian economy seems to be on a roll. India-Pakistan relations are not on the boil. The monsoons have been good and, above all, Indian companies have posted spectacular sales and profit growth. "India is doing a great job. And the growth is across all sectors. Return on equity is rising by the day. Why wouldn't you invest in India?" asks Nilesh Navlakha, director, Deutsche Bank, New York. If these factors are pulling investment into India, several factors are pushing it out of other Asian markets. South Korea, for instance, is facing threats from its bellicose half-brother while China has only just begun to open its markets to FIIs. "India fits in well as the investment destination. FIIs don't like regions where there is a fear of a conflict," says U.R. Bhat, head of equities, JP Morgan India.

Adding to India's attractiveness has been an extended bear phase of the past two years. That has made many potentially blue-chip stocks cheap and FIIs have been lapping them up. Most importantly, FIIs seem to have sensed that it is only a matter of time before small investors enter the markets because falling interest rates have made traditional investment options like bank deposits and government bonds less attractive. About 120 FIIs were among the bidders in the just concluded Maruti Udyog IPO. Of these, 30 were investing in India for the first time. Only 50 FIIs had bid for the i-Flex Solutions public issue last year. "We got interested in India a year ago because of very attractive valuations," says Julie Pfeffer, emerging markets equity analyst with Du Pont's pension fund arm.

If low-priced stocks attracted investment in equity markets, the higher than global rates of interest in India brought in investment in the debt market. Says Falguni Nayar, executive director, Kotak Securities, a joint venture with Goldman Sachs: "Interest rates in the US are around 2 per cent. The huge differential between interest rates in the US and India is one of the driving forces."

The capital market reforms of the past two years had added to India's lure. Conservative foreign investors, especially pension funds, have traditionally stayed away from markets where there are risks like fake and stolen shares, delay in share transfers and long settlement cycles. Most shares have already been dematerialised, thus reducing the risk of fakes. In 2001, Indian markets finally moved to rolling settlements-where the trading cycle is reduced to a day-and in two years has moved from a T+5 (where shares are delivered or cash paid before the fifth day) to a T+2 (second day) cycle this year. This is faster than even many developed markets.

The only discordant note in this well-orchestrated upsurge is the increasing presence of hedge funds. These are funds that make money by frequently buying and selling stocks across markets to benefit from arbitrage opportunities. Unlike most FIIs whose earnings are fee-based and therefore not dependent on the returns from investment, hedge funds' only source of income are the returns from their investment. An estimated 35 per cent of all global flows are now from hedge funds and their popularity is gaining. Because these funds are more ruthless than long-term investors, they are scorned in most countries and fears are also being raised in India. Brokers say the entry of hedge funds will bring greater volatility because they are quick to dump stocks and get out of a market at the slightest hint of a fall in prices.

While at least 30 large pension funds have registered themselves as FIIs in the past few months, brokers say that several hedge funds have been investing in India through the participatory note route. In this, a foreign broker buys and sells on behalf of a client. But instead of giving the shares, the broker issues participatory notes. But Puneet Chaddha, senior vice-president, custody and clearing, HSBC, which accounts for 50 per cent of all FII accounts and sub-accounts, dismisses suggestions of volatility. "The money coming in looks dedicated to India," he says. "They are very bullish."

For the party to go on, a key challenge would be to create enough supply of good scrips in the market. FIIs have typically only invested in top 100 scrips. "FIIs already account for almost half the floating stock in the top scrips. There is need to create fresh demand through big ticket IPOs to feed their appetite," says Bhat. Adds Navlakha: "Pushing privatisation on a big scale could be one option." The Government must also ensure that the snarling fiscal deficit does not hamper the economic recovery.

With equity mutual funds not seeing any great inflows and retail investors still sitting on the fence, FIIs have come to dominate the stock markets. Days when FIIs have not bought aggressively, the markets have slid. This dominance is, however, expected to recede once retail money comes to the market. On the other hand, a bigger presence of FIIs means more depth to the markets, greater research and more information to the investor. For the time being, this is one foreign infiltration that no one is alarmed about.

-with Anil Padmanabhan